Burned in December, markets see slim chance of ECB action this week

[LONDON] Financial markets have priced in only a marginal chance the European Central Bank will cut interest rates this week, even with oil prices at just over half the levels the ECB's 2016 staff forecasts are based on and long-term inflation expectations at their lowest in more than three months.

Eurozone bond yields edged higher on Monday and short-term interest rates held steady in a sign of caution after ECB President Mario Draghi failed to meet the market's expectations in December.

He delivered a cut of 10 basis points in the deposit rate, to -0.30 per cent, and extended the programme of 60 billion euros a month in asset purchases by six months, until March 2017. Before the meeting, the ECB had seemed to signal deeper rate cuts, an increase in monthly purchases and other measures.

Draghi had built a reputation for surprising financial markets with the force of his actions ever since a 2012 pledge to do "whatever it takes to preserve the euro". Markets have been seen unprecedented monetary stimulus since the global financial crisis erupted in 2008.

"I do not recall other policy meetings where Draghi surprised the market in such a negative way," said Rabobank senior market economist Elwin de Groot. "That signalled to me reluctance to do more." Reuters exclusively reported last week that many ECB policymakers are sceptical that further policy action is needed for now, after conversations with five of them.

German 10-year Bund yields, the benchmark for euro zone borrowing costs, were up 1 basis point at 0.48 per cent, having fallen around 25 bps from the highs hit after the December meeting. Yields have been pushed lower by oil's freefall and concerns over an economic slowdown in China.

"The ECB is not expected to make any decision to ease monetary policy further this week," said Alexander Aldinger, senior analyst at Bayerische Landesbank. "The tone should, however, be somewhat more dovish after the disappointing December meeting."

Oil prices hit US$27.67 a barrel on Monday, their lowest since 2003. The ECB's 2016 staff forecasts - which see economic growth at 1.7 per cent and inflation at 1.0 per cent - assume oil prices of US$52.20 a barrel.

Sensitive to moves in oil, long-term inflation expectations as measured by five-year, five-year breakeven forwards . They reached their lowest levels since early October, below 1.60 per cent.

The measure, which shows where markets see 2026 inflation forecasts in 2021, has fallen more than 20 bps since the December highs. It is now less than 10 bps above troughs hit in January, a week before the ECB announced quantitative easing.

One-year inflation swaps at just below zero show the market expects inflation in the short term to fall from current levels of 0.2 percent rather than head towards the ECB's target of just below 2.0 per cent.

Two-year inflation swaps are a tad below 0.3 per cent. Thirty-year inflation swaps are just above 1.6 per cent.

A weaker euro would help lift inflation and boost exports, but at $1.09 it is almost 4 per cent stronger than it was the day before the December meeting.

Judging from the difference between spot overnight interbank lending rates and forward rates dated according to the ECB meeting calendar, money markets are pricing in a less than a 10 per cent chance rates will be cut a further 10 basis points in January.

The probability rises to 50 per cent in March, when the ECB staff forecasts are updated, and 100 per cent by mid-year. "Given that the ECB based its inflation forecasts using an assumption of ... ($52.2) oil, downward revisions are likely and consequently speculation of further monetary easing seems set to grow," said Mark Dowding, Partner & Co-Head of Investment Grade Debt at BlueBay Asset Management.

REUTERS